What Are Interest-Crediting Methods?
An interest-crediting method determines how interest changes to a fixed index annuity (FIA) are measured. The interest-crediting method chosen measures the amount of interest that the annuity holder can receive over a specific time period.
Annuity contracts have a number of provisions that affect how interest is treated. Most contacts include a combination of caps (maximum interest allowed), participation rates (fraction of interest credited to the contract) and spreads. These limit the upside potential of increases in index value.
- Interest crediting methods are approaches to determining the cash flows due to annuitants on an indexed annuity.
- Standard fixed annuities credit annuitants at a fixed rate linked to treasury securities issued by the government.
- For indexed annuities, the crediting method requires a formula that may take a monthly average of a stock index's price movements.
Understanding Interest-Crediting Methods
Indexed annuities return cash flows linked to the performance of an equity index, such as the S&P 500 index, but with a cap on the maximum return that will be credited. In a point-to-point interest-crediting method, any increase in the value of an index is calculated from two points in time. This is the simplest interest-crediting method to calculate, but it may not provide an annuity contract holder with the most benefit. For example, if an index was valued at 1,000 at the beginning of the time period and increased to 1,150 by the end, the point-to-point method would call this a 15 percent increase (150/1000 x 100). If the index decreases in value no interest will be added to the contract, though the contract won’t lose its value.
A monthly average method takes the value of the index at the end of each month and averages them. This is as simple as summing up all of the end-of-the-month values and dividing by twelve. If, for example, an index started the year at 1,000 and the average index value was 1,200, then the monthly average would be 20 percent (200/1,000 x 100). This method may be considered during volatile markets.
The monthly sum method takes the percentage increase or decrease in the index each month and sums them up. The index may go into positive territory or fall into negative territory from month to month. If the percentages are added together and come out positive, then the interest will be credited to the contract. This method is the most sensitive to volatility.
Interest-Crediting Method Types
Interest-crediting methods differ for other types of annuities. Regular fixed annuities credit interest at a rate that is linked to the T-bills rate. Fixed indexed annuities, on the other hand, credit interest using formulas based on changes in specific indexes. The crediting method determines how much interest is credited to the annuity. The rate and frequency of the credits depend upon the terms and conditions of FIA contract.
Some of those alternative interest-crediting methods used by insurance companies include:
- Annual point-to-point averaging
- Biennial point-to-point averaging
- Monthly point-to-point averaging
- Daily averaging / monthly averaging
- Hindsight index strategy monthly averaging